Blog

27 June 2016

With the people of the UK voting to leave the EU at the end of last week, the UK and the EU have entered uncharted territory. Looking into a somewhat murky crystal ball, what does Brexit mean for private equity sponsors looking to invest in the UK or EU?

As the UK has to serve notice under Article 50 to leave the EU and enter into two years of negotiations (only extendable by the EU member states), there is no immediate impact on UK laws or the applicability of EU Directives to the UK, so in the short term the current legal and regulatory framework will continue. However, we enter another period of uncertainty until the terms of Brexit and the UK's new relationship with the EU (and the rest of the world in terms of new trade agreements) is settled.

In relation to any private equity deals that were put on hold pending the outcome of the referendum or new deals that are currently being considered, the fall in the value of sterling against all major currencies will make the UK cheaper for non-sterling denominated funds. Although, there will, no doubt, be continued currency and market volatility, given the further period of political and economic uncertainty that the UK and EU have now entered, it is hoped that many of these deals will now go ahead.

Many private equity investors have at their disposal lots of capital that they need to invest, and perhaps they may be able to take advantage of the current uncertainty to acquire assets at more reasonable prices relative to recent deal prices. Counter to that, strategic investors, Canadian Pension Funds, Sovereign Wealth Funds, new to market Chinese and Asian buyers, and other pension funds making direct investments are all directly competing for deals with traditional private equity sponsors, and also have access to lots of capital.

It is still unclear at this early stage what the impact of Brexit will be on the businesses of existing portfolio companies and businesses that private equity sponsors are targeting. There are however some indicators:

The Leave campaign majored on their desire to control immigration, potentially limiting the free movement of EU citizens and their current right to live and work in the UK. Similarly the converse may also impact UK citizens looking to live and work in the EU. This may lead to labour shortages and increased wage costs for businesses currently dependent upon migrant labour. Against that, it remains to be seen whether any changes to UK employment law introduced once the UK is extricated from the EU could result in a more flexible UK labour market offering a better landscape for UK employers.

Trading conditions for businesses will change. A falling pound should benefit UK exports (although new tariffs imposed on exports to the EU may mitigate that in the longer term), and conversely imports from the EU will be more expensive.

Regulated businesses in the UK are likely to lose the benefit of the EU passporting regime once the UK is no longer part of the EU, particularly relevant for financial institutions operating cross border. If the benefits of the passporting regime are lost, then regulated firms in the UK and those regulated elsewhere in the EU who are operating in the UK may need to establish regulated entities on both sides of the "EU border". In addition industries benefiting from harmonised standards across the EU, may in time also need to apply differing standards for EU/UK products and services, as law and regulation diverge. This will push up the cost of doing business.

During the hiatus before Article 50 is invoked (if indeed it is invoked) and during the two year (or longer) negotiation period that will follow, private equity sponsors and their portfolio companies will have some breathing space to figure out how to adapt their businesses to the new post Brexit environment, particularly as negotiation outcomes become clear.

Putting Brexit to one side, there are other factors likely to impact the private equity industry in the coming year. The new restrictions on deductibility of debt interest championed as part of the OECD's Base Erosion and Profit Shifting proposals to prevent tax avoidance are firmly on the horizon. As we get closer to 1 April 2017, and depending upon the detailed draft tax legislation that is expected towards the end of 2016, it will be interesting to see whether private equity sponsors in the UK start to de-lever their investments.

Also, what impact (if any) will the election of Trump or Clinton have on the private equity community globally?

And perhaps more importantly than all of the above considerations, what impact will disruptive technologies (which by their nature cross borders) have on existing portfolio investments/businesses currently owned by private equity funds? Inevitably there will be winners and losers, and working out 'which to ditch' and the 'best place to invest' will continue to be the key to fund success in the future.

Brexit will impact investments in companies in different ways, depending on the way it impacts the sector they operate in. Our infographic gives an overview of how those impacts are likely to differ across key sectors.